Summary Article

Should You Invest In Renewable Energy ETFs?

I recently received an email from a UK based listener of my podcast who finds it good company during his long drives from Cambridge to the Midlands.

He had bought a renewable energy exchange traded fund and wanted to know if I was bullish on renewables as a long-term investment spanning ten to twenty years.

While I replied to his email, I didn’t answer his question.

I needed to do additional research. Plus, from a regulatory standpoint, since I am no longer a registered investment advisor I’m not permitted to answer investment-related questions via email as it could be construed as investment advice. So I told him I’d write an article and do a podcast on the topic.

Why didn’t I have a ready answer?

Because in order to make money investing, it is not enough to be positive or bullish regarding some aspect of the economy, such as renewable energy.

I am definitely bullish on the continued build out of solar energy.

The Expansion of Solar Energy

According to data from the International Energy Agency and forecasts by the energy research publication TerraJoule.us, solar’s share of global energy capacity is expected to grow from 3% in 2014 to over 18% of global energy capacity in 2022.

Global energy capacity is different from global energy production as utility scale solar plants can only produce when the sun is shining. Consequently, solar energy production is expected to grow from 0.7% of global energy production in 2014 to 3.6% in 2022.

Falling Costs

As the price of producing solar panels plummeted from $3.50 per watt of power in 2005 to close to 50 cents today, the cost of building utility scale solar plants has also declined and will continue to do so. This more competitive pricing structure will result in utilities adding more solar power generating capacity.

According to TerraJoule.us, utility scale solar plant installation costs have fallen from $200 per megawatt hour in 2010 to $50 today. Cost of home installation of solar panels has also fallen sharply.

All this should be good news for solar companies and their stocks, correct?

No. For investing, what matters is not how fast an economic sector is growing but how fast it is growing relative to investor expectations.

In other words, investors in renewable energy companies need to understand what growth prospects are priced into that sector’s securities and what is the likelihood that the companies will exceed those expectations. Because if the companies fall short, then the securities can get decimated if expectations are too high.

Underperforming Investment

In the solar energy space, companies have consistently fallen short of expectations as profits have been erratic. Consequently, investors have paid dearly.

For example, the largest exchange traded fund in the alternative energy space is the Guggenheim Solar ETF (“TAN”). This is a pure play solar energy investment that invests in solar energy stocks around the world.

The ETF is concentrated with only 26 holdings. It was launched in April 2008 as the appetite for renewable energy stocks was voracious. In 2007, the average gain for solar stocks was over 200%.

In 2008 with the global financial crisis, solar stocks got crushed with the Guggenheim Solar ETF declining approximately 65% from its initial price.

Things weren’t much better from 2009 through 2012, as the ETF declined another 79%. But then solar stocks roared back to life in 2013 as the Guggenheim Solar ETF gained 128%.

Since 2013, solar stocks have come up short once again, with the Guggenheim Solar ETF falling another 38%.

Since its inception in April 2008 through June 30, 2016, the Guggenheim Solar ETF has returned -24% annualized.

Supply and Demand

What has hurt solar stocks is the law of supply and demand. While demand for solar panels has skyrocketed, the capacity to produce solar panels has increased by even more.

In a March 2016 research report, Credit Suisse stated “We believe solar manufactures face an exacerbated oversupplied environment in 2016; we tabulate the industry is planning on adding 10 gigawatt cell capacity to an already oversupplied market while we estimate demand only increases 6.1 gigawatt.”

Credit Suisse estimates demand for solar panels will increase at a 14.6% compound annual growth rate from 2015 to 2020. Yet, if the supply of panels grows faster than demand as it is expected to do this year, then producers’ profit margins will be squeezed, hurting profits.

The alternative energy space has been plagued by too high of investor expectations. The average five year annualized return for the top eight alternative energy ETFs is -4.8% for the period ending June 30, 2016. That compares to 12.1% for the S&P 500 Index, a measure of U.S. stocks, and 5.4% for the MSCI All Country World Index, a measure of global stocks.

Is Now The Time?

Has the disappointing performance for alternative energy investing lowered investors expectations? It certainly has in the solar energy space. The price-to-earnings ratio for the Guggenheim Solar Energy ETF is 7.3 compared to 20.0 for the MSCI All Country World Index. The ETF’s price-to-book ratio is 1.0 compared to 2.0 for the ACWI benchmark.

What is uncertain given the solar panel oversupply issue is whether investor expectations are low enough for solar companies to exceed them, allowing their stocks to appreciate substantially.